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Eng Course- Financial Analisys- Download Free PDF

IntroductionThis unit reviews basic financial analysis techniques. The issue involved is fundamentally this:investment in a project requires giving up consumption or other benefits in the current period, inexchange for consumption or other benefits in the future. How do we evaluate this trade-offbetween present and future values? This is what investment analysis is all about. We cannotsimply sum up the future net-returns and compare this sum with the project’s initial costs,because people have a bias in favor of benefits received in the present period. Hence, futurebenefits or costs must be weighted, or discounted, to convert them into current-periodequivalents. Once future returns are converted into “present value equivalents”, everything canbe summed up, allowing a comparison of the “present value” of the project’s net-benefits againstits costs.As a terminological note, the term “economic cost” has a very specific meaning to economists:it’s the opportunity cost of resources given up to do something. This may or may not be the sameas financial expenses or outlays, e.g., a hour of donated labor imposes an opportunity cost in theform of what the time could otherwise have been doing, even though there is no financial chargefor the labor. (See week 1 lecture notes: “A Substantive Course Overview”). In this handout,however, I will assume away the distinction between economic cost and financial outlays andexpenditures, assuming that financial outlays do represent economic costs and thus speakinterchangeably of financial outlays and economic costs. But note that this is very specific to thecontext; namely, it requires a shadow pricing assumption that financial outlays do equalresource costs. (This equivalence between financial cost and resource opportunity cost willchange later, when we consider the “shadow pricing” issue formally.) As mentioned in the week1 lecture notes, we abstract from the shadow pricing issue in this unit in order to focusexclusively on the fundamental features of investment analysis that arise whether or not there isa shadow pricing issue.Another important qualification is also needed at this point. In the previous handout, the“Fundamental Theory of Discounting,” we focused on the relationship between MRTPs and themarket rate of interest, R. In that context, individuals were simply borrowing and loaning thefunds they had to reallocate their mix of present and future consumption to better optimize theirconsumer choice. This is essentially the story of a trading economy in which no productiontakes place. For example, if I have $x of funds and you have $y, we might arrange a loanbetween us to better optimize our consumption opportunities between future and presentperiods, just as if I have a bushel of apples and you have a bushel of oranges, we might swapsome apples and oranges to better optimize our consumption of apples and oranges. Noproduction is involved in either case.